Technically speaking, compound interest is the interest you earn on interest. Practically speaking, it’s one of the most powerful means of investing and growing your wealth. Compounding can work for you or against you, depending on whether you’re investing or paying off debt.
Typically, compounding is discussed in the context of investment growth over time. For example, imagine someone purchases a financial product or has an interest-bearing account with an initial deposit. As interest is earned and deposited into the account, the balance grows. Then, future interest payments are calculated using the new balance, which includes the initial deposit (principal), and the interest earned.
If this cycle continues over long periods of time, it can lead to exponential growth in the account—as long as the investment is left untouched. To better understand the power behind compounding, let’s explore a few examples.
The Power of Compound Interest
Imagine that you had $100,000 to invest for 20 years. You’ve got a long time horizon, so you decide to be a little more aggressive with your investments and estimate that you can earn a 7% return each year. You’ve also decided that you want to harness the power of compound interest, so you choose to leave all the earnings in the account year after year.
So, what will your $100,000 be worth in 20 years? With the power of compound interest, your initial $100,000 would grow into roughly $385k—nearly quadrupling your money!
Not bad for letting your money work for you, but let’s explore another example.
Now here is the amazing part. Let’s say that instead of 20 years, you’ve got 40 years to let your money grow and compound. How much do you think you would have, assuming the same starting amount and annual growth?
Well, since you’re going from 20 years to 40 years, a reasonable guess might be that your money would be twice as big? So maybe you go from $385k to $770k?
The result is a whopping $1.5 million! That means that instead of being twice as big by doubling your timeline, your result is almost seven and a half times more. That’s the real power of compound interest and what it can do for investors!
It Works Both Ways
People often focus on the benefits of compound interest and how it can grow their wealth, but it’s essential to understand the other side of compound interest and how it can have negative impacts on your wealth. For example, certain types of debt can compound, and rather than earning interest—people find themselves paying it.
A typical example would be credit card debt. Credit card debt can compound, meaning that the interest one owes can be added to the debt amount, creating a new higher debt balance. Then the interest is calculated on the new higher amount, which begins to compound.
One way to avoid compound interest working against you is to pay the debt balance in full each month rather than make minimum payments. Making minimum payments can allow credit card debt to compound and grow over time, leading to much higher debt repayments. If the interest rate on your credit card is high, consider a balance transfer to a card with a lower rate.
How to Benefit From Compounding
For someone that is hoping to harness the power of compounding and use it to grow their wealth, here are a few tips to consider:
- Start early. The longer an investor’s timeline, the more powerful compounding can become. If you imagine a line graph, compound interest will show up as an exponential growth curve, meaning that: rather than a straight line up and to the right, it starts straight and then curves upward later on as compounding begins to have an effect. Remember in the example, by doubling one’s timeline from 20 to 40 years, you can increase your result by seven and a half times.
- Let it grow. Charlie Munger, a famous investor and partner of Warren Buffet, once said: “The first rule of compounding: Never interrupt it unnecessarily.” Thinking back to the example above—the reason that compounding had such a profound effect on the initial investment is that you could let it grow and compound over a long period without interruption. Unfortunately, investors are often their own worst enemy and fall victim to short-term market swings that can cause them to panic, sell at the bottom, then lock in steep losses. This type of interruption dampens the power of compound growth.
- Become an investor. To benefit from compounding, you will need an initial investment or recurring investment stream. For many, this takes the form of a retirement account or brokerage account, but you can also benefit from compounding in other types of accounts, which we’ll cover later on. Check out our article on how to set up a successful investment portfolio to learn more about diversification of investment accounts.
How to Calculate Compound Interest
When it comes to calculating the power of compound interest and the effect it can have on your wealth, there are a few different ways to approach it.
The first is to use a simple formula to calculate the impact of each year:
P = Principal (initial investment)
I = Interest rate
E = Earnings
Principal multiplied by interest rate equals your earnings for the year. Then, by adding the earnings to your principal, you can calculate your new balance. The next year, you would multiply your new balance (which includes principal and interest) by your interest rate and repeat the steps. Here is the formula:
Year 1: P x I = E, then E + P = year 1 balance
Year 2: year 1 balance x I = E, then year 1 balance + E = year 2 balance.
You can continue calculating the effect of compounding on your investment year by year.
Alternatively, you can calculate it by hand or with a financial calculator using the future value formula:
FV = Future value
PV = Present value
i = interest rate
N = number of periods (years)
Which Types of Accounts, Investments, or Debts Compound?
It’s important to understand which types of investments will compound in your favor and which types of debt can compound against you. Here is a look at some of the standard saving, investment, and debt types that can compound.
- Savings account
- Youth Savings account
- Money Market account
- Checking account
- Smart Checking account
- Certificates of Deposit (CDs)
Each of the account types listed above can earn interest on the deposit amounts. When this interest is added back to the principal and left untouched, the next interest amount will be calculated using principal and interest earned—this leads to compounding effects over time. Each account type will pay varying amounts of interest depending on the principal amount, type of account, or duration for CDs. For information on Teachers’ rates, check out our rates page.
- Equities (stocks)
- Fixed Income (bonds)
- Exchange-traded funds (ETFs) and mutual funds
The investments above can also benefit from the power of compounding in various ways. For example, equities and ETFs or mutual funds that are invested in equities can benefit from compounding in multiple ways. One way is through the accumulation and reinvestment of dividends, which are simply cash payments that companies make to their stockholders based on the number of shares one holds. By reinvesting these dividends, stock owners can benefit from an increase in shares, leading to compounding effects. Additionally, all of the investments listed above can benefit from price appreciation as the companies go up in value over time. For fixed income investments such as bonds or bond funds, there is typically a fixed rate of interest paid over time, as well as the possibility for price appreciation. For cryptocurrency, there is also the ability to earn a variable yield (similar to an interest payment) as well as price appreciation. It’s important to note that each of these investments can also go down in value, though typically long-term investors are rewarded by staying invested for long periods of time.
- Credit card debt
- Student loans (in deferment)
Debt that compounds can be difficult to pay off, as the balance can grow over time. For example, when making minimum payments on credit card debt, the additional interest owed each month is added back to the principal, and the next interest amount is calculated using the new total. For those making minimum payments, it’s easy for a debt to compound against them.
Similarly, certain student loans can compound while they are in deferment, meaning that the owner of the debt has placed payments on hold. When the deferment period ends, the interest that has been accruing throughout deferment is added to the principal amount to create a new, larger total. Interest payments are then calculated based on the principal and added interest, resulting in negative compounding effects against the
Teachers Federal Credit Union Is Here to Help
At Teachers Federal Credit Union, we want to help you grow your wealth by harnessing the power of compound interest. That’s why we’re offering a high-yield Smart Checking account, with a competitive 2.00% APY*, which is more than 22x higher than the national average.¹ With $0 monthly service fee, and interest compounding daily, credit monthly, it’s easy to grow your wealth and let your money work for you!
1 Based on Comparison of Average Savings, Deposits and Loan Rates at Credit Unions and Banks, accurate as of March 26, 2021.
*APY = Annual Percentage Yield.